Are hedge funds a good alternative to bonds?

“History does not repeat itself, but it does rhyme.” ~ Mark Twain

Daniel Insunza (Director, Investment Funds and Hedge Funds Singapore)

In recent months, the topic of hedge funds versus bonds has been a debate among many investors who are asking themselves what to do next. While equities may be one option, Daniel Insunza suggests that hedge funds offer a good alternative for investors seeking stable returns at a low volatility.

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If we look back over the last century, what was the longest time period that US bonds lost money, in real terms, and how sizeable would that loss have been?

Most investors today would look at their own experience and say six months, perhaps one year; when asked to put a number on the loss, they would probably say 10%. They might argue that bonds recovered quicker than equities and losses would be much smaller than the 50% lost during the tech bubble and the financial crisis.

Bonds are safe – or are they?

Historical evidence looks quite different: from December 1940 to October 1988, an investment in US bonds would have been ‘under water’ (yielding negative real returns leading to a loss in purchasing power), with the bottom of -50% reached in early 1980. How is that possible? Negative real returns happen when inflation is higher than interest rates. This is called financial repression and it is a policymaker’s chosen tool to ‘pay off’ a heavy debt burden (in this case incurred during World War Two).

Today’s investors have forgotten that fact: ever since 1980, bond investors benefited from ever decreasing interest rates, to levels not seen since the Great Depression, and to a point where, arguably, they can’t drop much further. Today, many developed countries face high levels of indebtedness. Financial repression is, once again, one policy option available. Hence bond investors may have to get used to lower returns from here on.

Equities are usually the alternative to fixed income investments. In a balanced portfolio, the lower expected return and volatility of fixed income typically complement the higher return, but also higher volatility, of equities. If the bull market in fixed income draws to a close, then the adverse sensitivity of bonds to rising interest rates may actually reduce total portfolio returns, while also adding to portfolio risk.

Evidence of this increase in risk could be observed during the month of June 2013, when the correlation between government bonds and equities shifted from -0.5 to +0.3.

This sudden move is of importance to traditional investors: an increase in correlation means that offsetting return streams from bonds and equities are no longer available and that the portfolio is exposed to the direction of markets, ultimately having more risk than anticipated and desired.

What to do now? Go back into equities? While this is part of the answer, we believe that a diversified portfolio of hedge funds may offer steady returns with a low (i.e. bond-like) volatility, without exposing investors to rising interest rates and with little correlation to equities.

The long and the short of it: Hedge funds offer a third option

‘Long only’ means buying and holding equities and fixed income instruments for an extended period of time. Most ‘long only’ portfolios, such as mutual funds, are typically evaluated relative to a benchmark such as the S&P500 for equities, or the Barclays Bond Index for fixed income. The outcome of a ‘long only’ investment mostly depends on two factors: market direction and timing.

Hedge funds, on the other hand, can actively trade equities, fixed income, credit, currencies, and commodities using a combination of both long and short positions. Unlike ‘long only’ investments, hedge funds define success as ‘making money’ and risk as ‘losing money,’ independently of the performance relative to other asset classes or indices. More than timing and market direction, the skill of the portfolio manager in taking investment decisions drives returns.

This ability to short and to trade means that foreseeable risks (such as a rise in interest rates) can be actively countered, while unforeseeable risks can be managed by strict risk management rules (such as stop losses). The evidence of a purely Fixed Income-oriented Fund of Funds suggest that this is possible: since November 1995, a bond index has had 66 negative months of -0.67% on average, while the Stable Alpha Ltd portfolio achieved a positive 0.31%. The hedge fund portfolio had the ability to perform positively while ‘long only’ fixed income lost money.

With bonds offering less return potential to say the least (refer to the 1940 to 1988 episode), hedge funds offer a good alternative for investors seeking stable returns at a low volatility. Selected Funds of Funds have been able to offer returns of 6.4% on an annualized basis, with a volatility of 4% over a long time period. So, if history does indeed rhyme, investors should consider choosing this alternative way of generating returns, using a wider range of investment techniques and keeping a keen eye on generating positive returns, regardless of which direction interest rates go.